The IRS has finalized rules for the deduction limitation on executive compensation which was revised by the TCJA. The 2017 changes further restricted the deduction, applying it to the five top executives of large publicly held corporations, including the Principal Executive Officer (PEO), the Principal Financial Officer (PFO) and the three others highest-paid employees. TCJA also removed the exemption for commissions and performance-based compensation, such as stock options, cash bonuses and some deferred compensation, making these types of compensation subject to the $1 million annual deduction cap.
After releasing a Notice in 2018 that narrowly construed grandfather rules and proposed regulations in 2019 that covered definitions and binding contract rules, the IRS final rules retain the basic approach and structure of the proposed regulations, with revisions in the following areas:
- the definition of a “publicly held corporation”
- the definition of a “covered employee”
- what is included in covered “compensation”
- how the limits apply when a privately held corporation becomes public
- what constitutes a binding contract and a material modification for purposes of the grandfather rules
Important changes are described in more detail below.
Publicly Held Corporations, Covered Employees
A corporation is a publicly held corporation if, as of the last day of its taxable year, its securities are required to be registered or it is required to file reports under the Securities Exchange Act.
A “covered employee” for any taxable year includes any employee of the corporation who is among the three highest compensated executive officers for the taxable year, regardless of whether the officer is serving at the end of the corporation’s taxable year and regardless of whether the officer’s compensation is subject to disclosure for the corporation’s last completed fiscal year under the SEC rules.
Also included are employees who were covered employees of any predecessor of the publicly held corporation for any preceding taxable year beginning after December 31, 2016. The proposed regulations stated that, if an acquirer corporation acquires at least 80% of the operating assets of a publicly held target, the target corporation is a predecessor of the acquirer corporation. One commenter suggested that the final rules clarify that the operating assets refer to gross operating assets instead of net operating assets, and the IRS adopted this suggestion.
Compensation, Partnership Interests
Compensation means the aggregate amount allowable as a deduction for services performed by a covered employee, whether or not the services were performed during the taxable year. The final rules also note that compensation includes remuneration includible in the income of, or paid to, a person other than the covered employee, including after the death of the covered employee.
Under the proposed regulations, a publicly held corporation that holds a partnership interest must take into account its distributive share of the partnership’s deduction for compensation paid to the corporation’s covered employees and aggregate that with the corporation’s deduction in applying the deduction limitation.
Commenters suggested that remuneration paid by a partnership is not compensation subject to the limitation because the partnership is neither a publicly held corporation nor a member of an affiliated group. However, the IRS rejected this idea, stating that the adoption of the commenters’ suggestion could lead to the use of partnerships as a method of avoiding the deduction limitation.
Also, under the proposed rules, this requirement would have applied to compensation paid by a partnership for a tax year ending on or after December 20, 2019. The final regulations delay that special applicability date to compensation paid for a tax year ending after December 18, 2020, the date the final regulations were made publicly available.
Private Corporations that Become Public
When a private corporation becomes a publicly held corporation, the deduction limit applies to compensation for the taxable year ending on or after the date that the corporation becomes publicly held. A corporation is considered to become publicly held on the date that its registration statement becomes effective.
The final regulations adopt the transition relief set forth in the proposed regulations. A privately held corporation that becomes a publicly held corporation on or before December 20, 2019, may rely on the transition rules provided in earlier guidance, and the final rules do not change that date. The final rules clarify that a subsidiary that is a member of an affiliated group may rely on transition relief if it becomes a separate publicly held corporation (for example, in a spin-off transaction) on or before December 20, 2019.
Other special applicability dates relate to binding contracts and when a material modification occurs that invalidates the grandfather rules. In general, taxpayers may choose to apply the rules for taxable years beginning after December 31, 2017 and before December 18, 2020, provided the taxpayer applies them in their entirety and in a consistent manner.
Transition relief leads to opportunities for planning, so adopting different effective dates should be undertaken carefully. To understand how these changes impact your business please reach out to your Frazier & Deeter advisor.